Tax Guidelines for Owning and Renovating a 2 Family

Renovations first.

Some stuff you're probably doing will be classified as capital improvements and can be written (depreciated, actually) off over a period of time. I think it's 27 years for building improvements (like ripping out and rebuilding kitchens and bathrooms) and 7 years for any new appliances you put in. If any of this work actually benefits the building as a whole (e.g. new paving in the garden), then you can only apply a portion of the cost to the rental depreciation, that proportion being the ratio of the rental unit area to that of the entire building.

Some of the stuff will be classifiable as repairs (e.g. replacing a leaky section of pipe) and can be written off as an expense, set against rental income, in the year that it was paid for.

I think, however, that you will probably have to state on your tax form that the apartment commenced being a rental unit at a date prior to any expenditures you will be claiming.

Beyond the renovation aspects you can claim depreciation on the value of the pre-renovated rental unit. To calculate the starting point (or cost basis) for this, you take the total cost you paid for the house, deduct the land value, and apportion the resultant amount to the rental unit based on the square footage ratio described above. You can depreciate this value over the aforesaid 27 year period as long as the unit stays a rental.

For depreciation deductions there are various methods you can choose on your tax form. The most conservative method is the straight line method: the same amount for every one of the, say, 27 years. A more aggressive method is called "declining balance", where you take a bigger deduction at the beginning of the period and it reduces to nothing by the end of the depreciation period.

Any utilities that serve the whole building rather than just your portion (typically gas or oil heating and water - you probably have separate electric meters for your unit and the rental) can be proportionately written off against the rental income. You should also take the real estate taxes and mortgage interest payments you make and split them proportionately between the rental and your space. Of course you can still deduct, as appropriate, the tax and interest portion that relates to your unit on your 1040 form. All the rental income/expense crap will be done on Schedule E.

Stuff like cleaning supplies, advertising, agents fees, related to the apartment can, of course, get fully deducted against rental income.

Oh, on the depreciation deal, don't forget that this is not so much a tax deduction as a tax abatement. You will ultimately pay capital gains tax on the amount you depreciated when you eventually sell the building. This is over and above the capital gains you will be paying on any gain in excess of $500,000 on the remainder of the building (the old "buy something more expensive and you pay no capital gains on appreciation" rule got changed two or three years ago).

Posted by: johnife at October 4, 2007 3:58 PM

I had better add that I used the words "as appropriate" in the reference to deducting the "your-unit" apportionment of interest and real estate taxes on Schedule A of your 1040 because I can't actually remember, off-hand, whether the taxes are a deductible item on that form. You should check with your accountant, and that advice is equally applicable to the rest of my post which was intended solely as the "pre-accountant-visit" education you requested.

Posted by: johnife at October 4, 2007 4:49 PM